Why Neustar Could Fall

Its name may not ring a bell, but in the deep-in-the-weeds backwaters of the deeply-arcane, acronym-riddled world of telecommunications, Neustar (NSR) has been a standout.

It's best known for running the database that makes it possible for you take your phone number with you if you move or change carriers.

The database is a big business for Neustar, generating about 48% of its revenue. It's also profitable -- so profitable that with gross margins exceeding 65%, Neustar routinely produces impressive positive free cash flow.

Not surprisingly, its stock has doubled over the past two years.

Contract Up for Grabs

But there's a hitch: For the first time since Neustar started managing the database in 1997, the portability contract, as it's called, is up for grabs.

It's unlikely Neustar will lose it, at least entirely, but it's also possible the contract could be split with others, or the price Neustar is paid could be sharply reduced.

Therein lies our story.

Spun out of Lockheed-Martin (LMT) in 1999, Neustar has been all about databases that surround telephone numbers.

In recent years, to lessen the blow of being so heavily tied to one thing, it has been diversifying into such things as marketing analytics and security analytics. It's even the keeper of the dot-biz Internet domain.

But the heart of the company, even though its percent of sales has been declining, is the portability database.

As CEO Lisa Hook described it at a recent investment conference:

"It is an information exchange, or a registry service, that is used by every telecommunications service provider in the United States to create and complete telephone calls. So, it's a data service that injects information into every network that tells where every telephone number is, what its attributes are, and the physical location of the phone number. That's been extant in the industry for the past 18 years. It's a single contract with the entire industry, or a body that represents the entire industry. Private contract, paid for by all of the carriers. We've renewed it now four times."

Super-High Margins

The monthly costs billed to phone carriers are believed to be generally passed through to you and me, lumped in with other charges on our phone bills.

That's where those 65%-plus margins come in. While the price of the portability contract is fixed at a high price, expected to be $466 million in 2014, the push into security and marketing analytics also has high margin. They're high, Hook said at a recent investment conference, because cost of goods "is fairly low, because we're doing this all off of the data that we're already acquiring for free from our customers to provide back to them in providing those network routing and addressing decisions."

That's where this gets interesting.

As far back as 2006, Telcordia, now part of Ericsson, began petitioning the Federal Communication Commission to put the contracts up for bid. With Neustar's contracts expiring in 2015, it did -- putting out a request for proposals.

"We expect that there will be significant competition as a result of this process," Neustar warns in its 10-K.

It's unknown just how much competition, but this much is clear: A decision, or at least a recommendation, on what should happen with the contracts was expected in August. It was then pushed out, without explanation, to January.

Neustar Remains 'Confident'

In response to the delay, Neustar said it remains "confident" it will retain the contract. And, besides, the company is quick to point out that its non-portability business is growing faster than portability. Jonathan Ho of William Blair is so unconcerned that a month ago -- when the stock was roughly where it is now -- he went so far as to upgrade Neustar, saying in a report he believes it "will likely be selected as the sole provider" of the contract.

The company had made "significant investments in infrastructure to extend the value of the ...database," Ho added.

Still, he believes the price Neustar will be cut by 20%, "partly offset by continued growth in transactions, resulting in a 15% revenue decline in 2016."

And some critics believe the cuts will or should be greater -- largely because of the same high margins that have made it so attractive to Wall Street.

One unidentified investor in large telecoms is so incensed by Neustar's margins that it hired Latham & Watkins attorney Matthew Brill to lobby for lower prices. In a letter to North American Portability Management, which represents the telecoms, Brill argued that the contract should have margins that "conform to more appropriate expectations for this type of quasi-government contract."

In other words, more like 8% or 10%, rather than 60%-plus.

In response to the letter, a Neustar spokeswoman said: "This letter from an unnamed source outside of the process does not take into account the complexity of managing the critical infrastructure that the communications industry and consumers rely on. Given the tremendous value Neustar has provided to the industry, and will continue to provide under the extension of the contract, we are confident in our proposal to remain the local number portability administrator."

T-minus three-and-a-half months, give or take, and counting.

Reality Check

Yes, I know, this story is a 10 on the arcane scale. That's unavoidable, given the world in which Neustar operates.

That's part of the problem: The story is so eye-glazing obtuse that it gets little attention, which is just when blindsiding can occur the most.

In a recent report, The Capitol Forum, which has ties inside the Beltway, wrote that according to its research, including "several sources close to the FCC process," it believes that Neustar "is likely to lose the high margins" on its portability contract.

If so, all bets are off.

Of course, nobody can say with certainty how this will shake out. It really boils down a risk/reward game for longs and shorts. But the risk of something unexpected is real, and we've seen this multiple times in patent disputes, court cases and regulatory decisions. They simply don't always go the way consensus expects.

Given the way the stock has treaded water since the William Blair upgrade, it would appear investors agree.